Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 170

The other problem with volatility

Investment volatility is the talk of the town in the wake of the Brexit vote, nervousness about future US leadership and slowdowns in key sectors (commodities) and countries (China). Volatility is a challenge for anyone managing a portfolio. For example, large superannuation funds must manage their members’ capital in a way that helps their members answer questions like: When can I retire? How much can I expect to have to live on during retirement? How much investment risk do I need to accept in my portfolio to meet my retirement goals?

The investment journey

Discussions about the damage volatility can do to an equity portfolio tend to focus on the investor’s journey and how to smooth ups and downs to increase the investor’s confidence and reduce fear of loss, or serious diminution of capital. This is described as the ‘journey problem’ and a number of solutions are emerging to address this.

Simple responses include moving to risk-adjusted investments and favouring equity portfolios with innate defensive characteristics (e.g. investments with counter-cyclical or inflation-hedging qualities).

Sophisticated investors are increasingly considering more complex, targeted solutions like purchasing downside, tail risk protection, or volatility dampening. This can entail investing in derivatives that pay off during market downturn events or running a volatility strategy where the value moves in the opposite direction to the underlying equity portfolio.

What these responses are missing is the fact that volatility creates not just a journey problem for the investor but also what we might call a ‘destination problem’, where volatility creates a phenomenon called the ‘variance drain’.

Variance drain is a drag on returns. It can be illustrated in the following example where we compare two hypothetical $10 million equity strategies. The two strategies have delivered the same arithmetic return at the end of a five-year period of 15%. One has experienced no volatility (‘No vol’ in the table), while the other has experienced volatility (‘Vol’) over this time period.

Source: A Wide-Angle Lens View of Volatility: Managing the Journey and the Destination, Parametric Research, July 2016.

We see here that relative to the No vol portfolio, on a geometric (compounding, linked) return basis, there is a return drag from volatility (in our example) of 61 basis points, or $60,777, over the five-year period. Larger portfolios, higher returns, higher volatility or longer time periods can all potentially increase this ‘leakage’. The return drag from volatility is akin to other hidden leakages in implementation like fees, taxes and transaction costs that can furtively and assiduously eat away at an equity portfolio’s value over time.

Watch the journey and the destination

The principle of variance drain should remind superannuation funds and other sophisticated investors seeking to address volatility that it is a two-dimensional problem. A solution which simply removes some risks on the downside may indeed solve the journey problem but the costs associated with this solution can mean that the investor’s destination (in a superannuation fund’s case, member retirement balances) is compromised.

Portfolio managers need to avoid the return drag from either living with volatility or addressing it in a costly way, as well as smoothing the journey. While solutions which look to solve both problems are few and far between, they do exist and are generally constructed to reduce volatility in a cost-sensitive way; for example, by using out-of-the-money rather than in-the-money derivatives. They also seek to find a replacement source of returns to continue the important task of building the overall value of the portfolio. Such strategies take a ‘wide-angle lens’ view of volatility and can be found in the hands of a specialist implementation manager.

 

Raewyn Williams is Director of Research & After-Tax Solutions at Parametric, a US-based investment advisor. Parametric is exempt from the requirement to hold an Australian Financial Services Licence under the Corporations Act 2001 (Cth) in respect of the provision of financial services to wholesale clients as defined in the Act and is regulated by the SEC under US laws, which may differ from Australian laws. This information is not intended for retail clients, as defined in the Act. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at www.parametricportfolio.com/au.

5 Comments
b0b555
August 27, 2016

Isn't this just one example of many possible scenarios, many of which would produce higher returns for the Vol portfolio?

stephen
August 26, 2016

I love it how volatility is used as a catchphrase to explain underperformance, when in fact vols are REALLY low right now (and correlation incredibly high). Notwithstanding yesterday's blip, vols have been crushed to sub-10 on SPX. If you don't believe me then check the VIX. Please don't use it as an excuse. Yes brexit happened, but that was two months ago. Move on.

Alex
August 25, 2016

Dave is right that 'professionals' use log or continuous compounding returns or IRR which removes the apparent anomaly, but this should not take attention from the main problem raised.

Dave
August 25, 2016

The maths trick is well known but if you compare two investments with the same IRR or compound return you do not get the problem - most professional investors would forecast compound returns rather than average returns.

Gary M
August 25, 2016

Good message. Spot on with the core problem – that is that ‘volatility’ and ‘risk’ tolerance has for the past 20 years been a question of: “you’ll get your 8% return (or $100k pension) but can you tolerate the ups and downs along the way to get there?” That is a horrible understatement of the real risk. The real question is “there is a good chance you won’t get your 8% return or your $100k pension – how do you feel about living on $70k instead?” So it is right to say the real problem is a ‘destination problem’ and not merely a ‘journey problem’

 

Leave a Comment:

     

RELATED ARTICLES

Red pill or blue pill? Navigating the matrix of fixed income

Understanding foreign exchange risk

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reason to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies will benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated investors' can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.